Before I raise your expectations unduly, I am not saying that Ben Stein’s entire “Everybody’s Business” column today is intelligent. However, this week’s piece, “It’s Time to Act Like Grown-Ups,” had some sensible moments, and I want to give Stein his due on those infrequent occasions when it is merited.

I am not parsing the entire article; I’ll just point to what I found to be the low and high points. First, the goofy part:

Here is a simple truth: As we know, Merrill Lynch, Citigroup, Bear Stearns and other financial entities have taken immense charges on their holdings of bundles of subprime mortgages, collateralized debt obligations and loans made in connection with mergers and acquisitions and for general commercial purposes.

But these deals did not just come out of the blue. Someone sold these debt instruments to these huge banks and investment banks. The someone might have been a borrower who was not qualified, or another player in the financial field like a hedge fund or a mortgage originator.

If the buyers are now realizing that these instruments are worth tens of billions less than they paid, someone else must have booked a roughly corresponding gain. Now, it’s true that the seller might not have realized that he had the gain. He might have sold at what he thought was fair value at the time. It may be that only when the credit correction started was the asset in question marked down to problem levels.

When Stein is off kilter, it’s hard even to know where to begin.

Let’s start with the most obvious problem: If X sells something to Y, and the price of the good sold falls later so Y suffers a loss, X had a gain.

That sort of thinking puts both parties on a mark-to-market footing, and that has the effect of treating opportunity gains and losses as real gains and losses. But whether X really gained depended on what he did with the proceeds, If he exited the market and took cash, then yes, he did better than if he continued to hold the asset. But if he instead traded into another asset whose value fell even more, he could have come out even worse.

It may be easier to see the point if we talk about appreciating rather than depreciating assets. It’s common for investors to sell part of an appreciated position to take profits. Even though they recognize the security may keep going up, they decide to risk losing some additional profit to reduce their downside. An investor, such as a retiree, may also sell part of their holdings to fund consumption in accordance with a financial plan. Similarly, an institutional investor may sell a certain type of asset because he has asset allocation guidelines and changes in the values of various asset classes have put him outside his objectives.

Yes, you can say they would have done better in narrow profit and loss terms to have held on, but in all these examples, profit maximization wasn’t the only consideration. So again, the idea that they “lost” is specious.

That is perhaps a long-winded way of saying that decisions to sell assets aren’t simply about maximizing financial market returns. Investors have different preferences, so a trade in line with their preferences, risk tolerance, and liquidity needs isn’t a loss in the way Stein characterizes it.

The other problem is that Stein misses what drove the fixed income mania. It wasn’t the the opportunity for trading gains that Stein alludes to. It was the fees.

In the old days, banks and investors held assets and realized spreads over funding costs over time. But new-fangled financial structures have promised to deliver investors all kinds of great new paper (example: creating enough AAA rated paper to meet previously unsatisfied demand). The product designers and other participants in the product creation chain have managed to find bagholders of various sorts and have managed to suck fees out of them. Why the bagholders got snookered is the subject of a much longer conversation, but there were chumps a plenty.

So what happened to the investment banks, ironically, isn’t Stein’s model that they wound up on the losing side of the trade. No, at least in Merrill’s and Citi’s case, they were hoist on their own petard.

Merrill’s former CEO Stan O’Neal got rid of his head of structured products in 2006 because he did not want to increase the size of the business. He knew the market was getting saturated. O”Neal put a new chief in who was willing to commit to growth targets. So Merrill kept creating new structured investment product but was unable to place the full amount of the transaction with investors. They kept the rest on their balance sheet. (That, by the way, is incredibly bad practice. Merrill should have taken the price reduction needed to unload the rest of the deal). And they kept originating more deals and winding up with more unsold portions. They rationalized that they were a good risk and learned otherwise.

In a like vein, Citi was originating and selling similar structured products (collateralized debt obligations), but Citi’s wrinkle was that they had changed the design (of course to increase their profit) so that a tranche (the “super senior” tranche) was commercial paper. CP only goes out to a maximum of 270 days, but the CDO entities have longer lives, so Citi would have to find new CP buyers whenever CP matured.

Starting in August, investors started shunning asset-backed commercial paper, including Citi’s CDO-related CP. Cit could have let the CDO entities sell part of their assets to reduce their funding needs, but that would have created a lot of havoc, both in the CDOs and in the market. So Citi instead bought the CP itself. And that CP has fallen in value.

So if we use Stein’s win-lose model, the investment banks were losers because instead of selling paper (which they were selling only to generate fees) to third parties, they effectively sold it to themselves. These were tantamount to internal trades, self-inflicted wounds.

Now to the sensible part of Stein’s article:

….much has been made of the failure of officers and directors to notice that something was amiss at these big banks. Why didn’t the directors ask the chiefs, “Gee, how can you continue to earn a far higher rate of return on debt than the market rate? How are you defying gravity this way? Can it last?”

Why were the questions not asked?

Possibly because the directors might have been chosen with an eye toward political correctness instead of an eye toward what they knew about finance and accounting. I was staggered when I read about the backgrounds of the Merrill directors. It is nice to have leaders of colleges and universities on boards (as Merrill does) but wouldn’t it have been better to look for accounting expertise? Was the idea to conform to P.C. principles and not have anyone asking tough questions? What about fiduciary duty?….

Next, when I saw that Citi had taken a bath in collateralized debt obligations and subprime, and saw that Robert E. Rubin had been on the board in a major position and had failed to stop the train wreck, I was staggered. And now he has been named chairman. He couldn’t protect Citi’s stockholders, and now he’s in charge? And let’s remember, he was Treasury secretary when we had the first part of one of the worst bubbles in stock market history. What on earth are the Citi directors thinking?

Stein is absolutely correct to point to both the lack of deep enough expertise and enough tough-mindedness among investment bank directors. A dated but still relevant example: Richard Gelb, who turned his family’s business, Clairol, into an industry leader and became CEO of Bristol Myers when it bought Clairol, was a director of Bankers Trust. Now a man like Gelb would seem be unsuited to be a director of a financial services firm, particularly one that was a cutting edge derivatives player. But Gelb was a self made man, and not shy about asking pointed questions. He made himself hated by the Bankers Trust management, but in the end even his forceful inquiries weren’t enough to keep BT from getting into insurmountable trouble. And that was when the industry and the products were vastly simpler than they are now.

Gelb’s ultimate failure, despite his determination, proves out Stein’s point about political correctness, that board members chosen for how their bios will look in an annual report are unlikely to have the expertise to enable them to provide effective oversight of an investment bank.

I’ll take the argument one step further. Investment banks should not be public companies. We will put aside the most important reason, namely, that investment banks were far more prudent when they were putting partnership capital, rather than other people’s money, at risk, and the costs of having investment banks play with other peoples’ money are turning out to be awfully high. They can and are creating messes whose costs extend well beyond their shareholders and employees.

Investment banks are composed of multiple businesses with demanding requirements for managing them. Historically, the businesses have been overseen by people who grew up in them and knew them intimately.

It isn’t acceptable in a modern public company to have a board composed largely of insiders, but that’s what you need to have effective oversight of securities businesses, although that also puts the foxes in charge of the henhouse (the whole point of having external directors is to act as a check on insiders). And the few recent high profile retirees, or say heads of institutional investors that might some relevant knowledge would often be perceived to be cronies rather than independent.

But to Stein’s point about Rubin’s failure to act: it seems likely he chose not to know about the trouble spots. With Sarbox, I would not want to be on the finance or audit committee of a sprawling financial institution like Citi. And Rubin wasn’t.

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13 comments

I agree with Stein about Rubin. Rubin was at the helm when the original sin, the Nasdaq bubble, happened, and he didn’t do a damn thing.

Even if Rubin hadn’t been on the audit or financing committee, he should have known what was going on. Hell, the people at Calculated Risk knew what was going on back in 2006, and they weren’t on the audit or financing committees of Citi either.

“ Let’s start with the most obvious problem: If X sells something to Y, and the price of the good sold falls later so Y suffers a loss, X had a gain.”

The error here, which you correctly point out, is profoundly fundamental.

Here’s another way of illustrating it:

The starting position is that at the margin, X has wealth W in the form of a good; and Y has wealth W in the form of cash. Their combined macroeconomic wealth is 2W.

They swap positions. At the instant of the swap, the combined macroeconomic wealth is still 2W.

Later, the good now held by Y declines, say to 0. The combined macroeconomic wealth is now only W, entirely held by X. Assume no change in X’s wealth W, because any further change in the value of the cash wealth W taken over by X is a completely separate issue with separate economics and separate from this problem under discussion, which is the deterioration in the value of the good finally held by Y.

X has had an opportunity gain; Y has had an opportunity loss. They net to 0 at the macro level. Opportunity wealth changes at the micro level are irrelevant to actual macro and micro wealth accounting.

I am a CPA/MBA and have worked for Big 8 CPA firms and think I know finance. No investment bank ever asked me to sit on its board. No one with an ounce of sense shouldn’t have seen the subprime mess coming. It’s the S&L mess of the early 1980s all over again, but larger. Where do these moron directors come from anyway?

The problem is not really with the directors. It’s with the positioning of the risk management function in these institutions. Senior risk officers quite often are near ‘rejects’ from the front line functions that have been placed in the penalty box to head up risk management. No front line bonus hungry master of the universe wants a risk job. This is a deep-seated cultural problem.

The purpose of capital is to protect against losses. The purpose of allocating capital is to maximize expected returns on a risk-adjusted basis. The quantitative models that support risk analysis (including CDO risk) and capital allocation are ever deepening. Big blow-ups are inevitably failures of risk analysis and prudent capital allocation, including avoiding concentration risk in one asset category.

The problem is that the capital allocation call is a CEO function, but the analysis it depends on is a risk management function. The risk function in these organizations is caught somewhere underneath the CEO and CFO functions. The directors who are expected to ask the ‘tough questions’ inevitably ask these questions of the chief risk officer. Conversely, the CEO often passes the buck to the chief risk officer when asked these questions. The directors often do ask these questions in committees. But there’s absolutely no way they can be expected to understand the substantial complexity of capital allocation modeling, let along CDO risk modeling. Sorry to say, but the directors are a joke in this regard – but more of a joke is the idea that they can be expected to understand much of anything deeper than the most superficial cut at the risk issues. This will never change. What may change in future is the risk DNA of CEOs.

Prediction: the fallout from this round of eminent write-offs will (once again) be a superficial elevation of the risk management function on the organization charts of these institutions.

I’m not defending the IBs, but the mentality was that if there was a buck to be made, they were going to make it. Liquidity was so abundant (remember Prince’s notorious “we’re still dancing” comment) that everyone thought they could exit when they needed to. And that pressure was heightened by being public (look ho O’Neal was obsessed with trying to match Goldman’s performance).

But they fell for their own sales talk (old hands at Lazard used to warn of the dangers of believing your own PR). Merrill, Deutsche Bank, Barclays and Morgan Stanley all bough mortgage brokers very late in 2006/early 2007 (the Merrill deal was in February) thinking they were buying near the bottom.

flory,

That video is actually kind of scary. People in suits yelling jingoism at each other passes for analysis? This illustrates why I don’t watch TV.

Anon of 8:40 AM,

Agreed, but I think (and hate to sound like a broken record) but this is again a function of public ownership. I’ve worked from time to time with proprietary trading firms, and the guy who was in charge of managing risk was usually either the most powerful or second most powerful guy in the shop.

When Salomon was private, John Gutfreund performed de facto risk management. He has his desk on the trading floor, and he was famous for his ability to read what was happening. He would regularly walk up to guys who were in or about to get in trouble and ask about their positions. He clearly regarded this as his most important job (why else hang out all day there if you aren’t running a trading desk?).

Similarly, at Goldman, risk decisions were tightly controlled (and defined more broadly than you might think). Example: only partners could quote fees or likely deal pricing (Goldman VPs got ribbed for it regularly, since their coutnerparts at other firms could do so).

I started blogging December 18, 2006, so there are no posts of any kind “a year ago” here.

But in January, I had quite a few posts on the worrisome amount of liquidity/leverage in the financial markets, complacency about risk, bizarre overconfidence, and yes, CDOs.

But (being new at the game) I didn’t see correctly how this would devolve (in fairness, no one anticipated a seize up in the money markets), I thought we’d see trouble with hedge funds that could damage the investment banks (basically, a rerun of LTCM but worse because, by virtue of being spread over multiple organizations, it would be difficult/impossible to orchestrate an orderly wind-down). I also said a spike up in oil prices (read: we get stupid with Iran and they close the Strait of Hormuz) could trigger a crisis.

So on a more generalized basis, this blog was talking about excessive leverage in the financial system basically from its inception, and anticipated that Things Would Turn Out Badly.

“ I started blogging December 18, 2006, so there are no posts of any kind “a year ago” here.”

Thanks for your response.

I’m very new to your blog, but have had about 30 years experience in banking. It certainly doesn’t surprise me from the quality of your posts and comments that you would be quite attuned to the head winds.

Interesting comment about public ownership – I visited the Salomon trading floor in the 80’s and saw Gutfreund in action – yes he was a legend. I never worked for a non-public bank but you’re probably right – public accountability no doubt breeds committees and blurring of responsibility. Having said that, the bank I worked for bought an investment dealer in 1988, rescuing it from near bankruptcy, after incredibly bad risk and capital management on a single underwriting deal.

More generally, my overreaction to one particular comment related to the unrealistic superman role expected for directors. My view is that’s the wrong generalized scapegoat in this case, as with most cases of risk. When it comes to capital allocation, asset mix, strategy, and risk, the role of the Board is to ask tough questions. It’s not to do the CEOs job. It’s not to do the job of the senior executives.

However, it is the directors’ job to choose the CEO, among other things. Probably the Merrill and Citi Boards could be criticized for this. The time when these banks could be run by glad-handing salesmen or lawyers (unbelievable) or even the latest incarnation of the ‘team player’ is past. These banks require CEOs who themselves have the intellectual capability to ask the right questions about risk and capital allocation so they can make the right decisions about asset allocation. The problem with these banks is not that they took these risks – it’s the concentration of these risk categories and their overreaching in their overall risk exposure – in other words, their asset allocation strategies – which is the same fundamental challenge as in investment management. Bank CEOS must be able to judge risk. They can’t delegate this skill set up to their directors or down to their staff.

Who knows? Maybe what I just wrote above is compatible with the old Salomon culture.

There are a number of blogs that have been predicting this – some since as long ago as 2005. Namely housing bubble blogs.

What was not understood in 2005 is that the housing bubble was in fact a credit/fraud/leverage bubble.

As it came to be understood that in fact the ‘housing’ bubble was really much more than that, the dots to lenders, hedge funds and investment banks were connected. And yes, this happened in 2006 – well ahead of what the sleepy media recognized.

I suggest you check the housing bubble blog, another f*cked borrower blog, or housing doom blog. You might be surprised what information was suspected *by complete outsiders*, and when.